What is Bitcoin?

What is Bitcoin? – A path not taken

Bitcoin is a decentralised electronic currency, devised in 2009 by a developer who has come to be known as Satoshi Nakamoto (although his true identity is unknown). The name Bitcoin is also applied to the free software designed by Nakamoto for the management of this currency, and the P2P network (peer to peer, or a network of “pairs” under the same protocol), which provides support. Unlike most currencies, Bitcoin’s operation does not depend on a central institution, but on a distributed database. The software invented by Nakamoto employs cryptography to provide basic security functions, such as the guarantee that the bitcoins can only be spent by one owner, and never more than once.

Bitcoin is one of the first implementations of the concept of crypto-currency, and without doubt the most successful so far. The proposal that inspired Nakamoto – of a form of electronic money that was impossible to monopolize, untraceable and that allowed its owners to remain anonymous – was first described in 1998 by the cryptographer Wei Dai in the famous mailing list Cypherpunk. The Bitcoin design, in fact, allows the user to possess and transfer value between public accounts in a potentially anonymous way.

Perhaps the greatest achievement of Satoshi Nakamoto was resolving the problem of double spending in a decentralised system, which has caused many sleepless nights for economists and programmers. To avoid the same bitcoin being spent more than once by the same person – in other words, to avoid falsification – the network makes use of what Nakamoto describes as a distributed timestamp server, which identifies and orders the transactions sequentially and prevents their modification. This is achieved by means of linked work tests, which appear as “confirmations”. Further on, it will be noted that this work is done by “bitcoin miners” in exchange for compensation in bitcoins.

While sending bitcoins is instantaneous, and any operation can be monitored in real time, the confirmations shown on screen when we use the Bitcoin software come to represent the “clearing” process. The greater the number of confirmations, the more remote the possibility of being victim of a double spend will be. When the network goes beyond five confirmations, a transaction is considered technically irreversible.

Security

It should be noted that, until now, no case of double spending has been documented, but it is certain that a cyber attack of this type is theoretically possible, provided that the attacker controls at least 51% of the computational power that protects the network. However, deceiving the network for a sufficient period of time to carry out a single double spend would imply such an enormous investment (the computing power of the Bitcoin network is several times higher than that of the 100 fastest supercomputers that exist, combined), and such complex organisation, that from an economic point of view it would be infinitely more profitable to put these resources to work under the rules of the Bitcoin protocol. On the other hand, the code has recently been modified to facilitate the detection and neutralisation of this type of attacks – whatever their motives might be.

The immense majority of those who accept bitcoins resign themselves to a single confirmation. For small amounts it is even reasonable to accept transactions instantaneously – before they have been confirmed by the network.

The information that authorises the control of the bitcoins that one possesses can be saved in any digital information medium (personal hard disk, memory card or stick, CD, web-mail box, etc.) in the form of a “wallet” archive, or looked after by websites that offer “Bitcoin accounts”. It is also possible to keep this information on non-digital mediums (printed on paper, for example) and even just in your head. Possession of the bitcoins can be transferred by Internet to anyone who has a “Bitcoin address”, like the way in which an email is sent to an email address.

According to the experts, thanks to Bitcoin’s cryptographic architecture, a transfer between Bitcoin addresses is many times more secure than a transfer between bank accounts – leaving aside the risk implied by the unavoidable intrusion by third parties in a banking system. The Bitcoin code is open to be examined by anyone who is interested, and allows future updates to confront potential attack vectors (necessary with decades of anticipation).

Summary

It might be said that Bitcoin works as a decentralised account book, in which the balances are not linked to the users but to the public addresses that they control. The history of all bitcoin movements remains stored in the block chain, a distributed database that maintains the register of all transactions in each of the multiple nodes that integrate the network (see below “Block chains”). These nodes are no more than host computers running the Bitcoin software all over the world, connected to each other by Internet.

The P2P nature of the Bitcoin networks makes the establishment of a centralised control of the whole system impossible. This prevents arbitrary rises in the number of bitcoins in circulation (which would generate inflation) and any other type of manipulation of the value by the authorities.

Technical information

The principles of the system are detailed in the Bitcoin Paper, written by Satoshi Nakamoto in 2008.

Addresses

Anyone who participates in the Bitcoin network has an electronic wallet that contains pairs of cryptographic keys. The visible Bitcoin addresses derive from the public keys of the user, and they work as the sender or receptor for all payments. The private keys corresponding to each public key allow for a determined user to authorise payments (transfer bitcoins) from his or her wallet.
The public addresses do not have any information about their owners; these appear as random sequences of numbers and letters of 33 characters in length, for example: 1rYK1YzEGa59pI314159KUF2Za4jAYYTd. Bitcoin users can have multiple addresses; in fact, they can create new addresses easily and without limits. Creating a new address is equivalent to creating a new pair of keys (public/private) and does not require any contact with the network nodes. Users who want to preserve their anonymity usually create a new address for each transaction.

Transactions

When one user A transfers bitcoins to another user B, user A renounces his or her possession of a determined number of bitcoins, adding them to B’s public key and signing the resulting combination with his or her private key. (Thanks to the use of asymmetric cryptography, the private key cannot be deduced from the signature from which it derives). This information is transmitted to the whole P2P network as a new transaction. Then, the rest of the network nodes verify the number of bitcoins involved and the authenticity of the cryptographic signatures, before accepting the translation as valid.

Bitcoin-Qt: Bitcoin software

Block chains

Any transaction transmitted to other nodes does not immediately become “official”; first, it must be confirmed in a list – maintained collectively – of all known transactions: the block chain. Such is the work of the “generator nodes”, owned by the “bitcode miners”.

Each node that generates bitcoins collects all the transactions that still have not been confirmed in an archive (candidate block) containing the reference to said transactions and the last valid block known by that node. Then, the generator nodes compete among themselves trying to find a hash of that block (a random code that represents it), in a computational effort that demands predictable amounts of trial and error. When a node finds the solution, it transmits it to the whole network. The rest of the nodes receive a new solutioned block, they verify it before accepting it and they add it to the chain.

Although no Bitcoin user is forced to reveal his or her identity, all the transactions ever made remain recorded in the database of free access that is the block chain. This contains the possession history of all coins (or fractions of coins), from the creating address to the address of the current owner, and it is found in all the host computers that run the Bitcoin software. Therefore, if a user tries to reuse coins that he himself has already spent (double spending), the network will detect it and it will reject the transaction.

The main chain (black) consists of the longest series of blocks from the creation (green) until the current block. Orphan blocks (grey) exist outside the main chain.

The block chain is a completely transparent register: anyone can examine it, at any time, to find out about any transaction that has been made since the launch of Bitcoin, as well as the new transactions that are added to the chain in real time. Several services facilitate this type of monitoring.

How bitcoins are generated

The Bitcoin network creates and distributes a batch of new bitcoins approximately 6 times per hour, to someone who is running the software for generating bitcoins (“mining” software). Generating bitcoins is known as “mining”, a term that refers to the mining of precious metals. The probability that a user receives a batch depends on the computational power with which he or she contributes to the network in relation to the computational power of all the other nodes combined.

The first generator node to find the solution to the cryptographic problem that the candidate-block presents is the one that obtains a new batch of bitcoins. The “miners” can also join together by Internet to generate bitcoins as a group, forming a “miner pool”.

The quantity of bitcoins created per batch never is nor will be greater than 50 BTC, and the rewards (the number of bitcoins per batch) are programmed to decrease with time, reducing the predictable increase in monetary mass, until reaching zero. There will never exist more than 21 million bitcoins.

So that a block may be generated every 10 minutes, every two weeks, the protocol updates the difficulty of the problem that all the generator nodes are trying to solve, adjusting it to the computational power of the whole network.

Due to the increases in difficulty to obtain bitcoins by means of mining, this has already been out of reach for the common PC user for a long time. Today, the majority of Bitcoin users obtain their crypto-coins in exchange for the products they sell, on trading sites, or in face-to-face transactions with miners or operators who buy bitcoins and sell them, charging a commission.

Transaction fee

Given that the nodes are not obligated to include transactions in the blocks that they generate, the bitcoin senders can voluntarily pay a transaction fee. On doing so, as well as accelerating the transaction, they provide incentives to users who maintain generator nodes (that is, to the miners). The generator nodes retain their value corresponding to the fees of all the transactions included in the blocks that they have solved.

These fees – when they are paid – are usually an insignificant fraction of the amount sent, if they are compared to those of any other value transfer system. For example, if we decide to send 100 bitcoins, the software might suggest that we pay a fee of 0.005 bitcoins.

The transaction fees will become more important the lower the reward is per block. In the future, the miners will be motivated to maintain the generator nodes with the sum of payments, by way of fees which can accumulate, more than by the bitcoins they are capable of generating.

Monetary quirks

Unlike enforced legal tender, Bitcoin cannot be controlled by any authority due to its decentralised nature. The expansion of the monetary base is predetermined by Bitcoin software and it is known by all, so that it is not possible to affect the buying/spending power of users by manipulating the number of bitcoins in circulation.

Bitcoin is an irreversible means of payment. Transfers are realised directly between the nodes, without a centralised process by a third party, which makes both involuntary reversing of payment and cancellation of mutually agreed transactions impossible. In this way, the sending of bitcoins is similar, in the benefits and risks it involves, to sending money in cash. However, many places offer services similar to eBay or the free market to facilitate the exchange of goods and services by bitcoins (for example, promoting the rating of other users and/or retaining funds until the two parties are in agreement).

The Bitcoin software (also called “Bitcoin client”) that users have installed in their computers transmits each transaction to the nearby nodes, which spread it across the network at the same time. Invalid transactions are rejected by honest clients (those who adhere to the protocol for the block chains in use). At the moment, the majority of transactions can be done for free, but we have already noted that it is possible to pay a fee so that the miners prioritise (accelerate) their processing.

The total number of bitcoins will reach 21 million over time. Their supply grows geometrically (at a constant rate); in this way, in 2013, half of the total supply will have been generated, and in 2017, three-quarters of it. As the quantity of bitcoins approaches the limit of 21 million, it is expected that the Bitcoin economy will enter deflation; that is, the spending power of each bitcoin will grow, probably until reaching a certain stability. The bitcoins, meanwhile, are divisible to 8 decimal places (giving us 2.1 x 10 raised to the power of 15 – 2.1 quadrillion – total units) and potentially even more, which removes the practical limitations to price adjustments in a deflationary context.

Bitcoins Supply over Time

The Bitcoin economy is still small if we compare it with other already established economies, and the software is still at the beta stage. However, all kinds of goods and services, from cars to freelance programming jobs, are at this moment being exchanged for bitcoins. Furthermore, there are a large number of websites that facilitate the exchange of all kinds of currency for bitcoins, and that permit a range of systems to transfer the funds.

What will the outcome be?

A possible failure scenario for Bitcoin is a global government campaign against the software and sites that accept bitcoins. However, given the nature of the system, Bitcoin’s total elimination (like any other P2P network) does not seem technologically or economically viable.

Nobody knows for sure what the destiny of Bitcoin will be; all that we know is that the idea of a decentralised crypto-currency is here to stay.

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